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Thursday, May 10, 2012

RBA and Treasury have misread strength of labour market

It turns out that the RBA has indeed (at least superficially) "misread" the economy, as so many commentators are keen to claim. Awkwardly, however, it seems to have materially underestimated the strength of our labour market, which its research suggests is the single most powerful predictor of future inflation.

Despite both the RBA and the Treasury forecasting that Australia’s jobless rate would rise to 5.5%, and using this as a key justification for lower rates (alongside a temporary decline in the prices of internationally traded goods and services), it appears, as I had previously argued here, that the peak in the unemployment rate is behind us.

According to the official statistician, Australia’s seasonally-adjusted unemployment rate fell to 4.9% in April from a downwardly revised 5.1% in March. But let’s avoid the temptation of looking at a single month of data. As the chart below clearly shows, the three month “moving average” jobless rate has been falling steadily since September 2011, ironically just before the RBA started slashing rates. It is now nearly a full percentage point below its 5.8% peak during the GFC.

The monotonic decline in the unemployment rate since the second half of 2011 tells us a few  things. First, the economy is not about to head into a protracted recession. Nor is the economy likely expanding at a rate that is significantly below trend (or capacity). In fact, the jobless rate implies that the labour market is near-fully employed. This in turn tells us that the economy is not in dire need of further interest rate relief.

Having said that, the volatile and prone-to-revision GDP data could very well confuse the issue. As the RBA has noted, the National Accounts are difficult to interpret when the country is undergoing a very lumpy and capital intensive private investment boom.

The second thing the unemployment rate tells us is that the high circa 3.5% per annum domestic (or “non-tradable”) inflation consistently recorded by the ABS is likely to be a permanent presence. In contrast, the “tradables” deflation induced by the striking appreciation in Australia’s exchange rate is, as I have explained before, a temporary event. Indeed, with the Aussie dollar now down about 8% from its 2011 highs, the deflation in internationally traded products that helped pull down Australia’s core inflation rate will likely have the opposite effect going forward.

You are unlikely to hear or read many of these arguments from other commentators. Most analysts are forecasting an increase in unemployment combined with a lower cash rate. Anyone with a commercial interest in the Australian equities and/or housing markets, including, importantly, almost all retail bankers, has been clamouring for rate cuts ever since the RBA appropriately tightened policy in November 2010. The Gillard Government, its lobbyists and public proxies, are pinning their fragile political prospects on below-average lending rates. And the hysterical complaints of the trade-exposed industries almost always overwhelm the silent savers and retirees.

It is interesting to contemplate what the RBA might have done at its May board meeting had it had the benefit of this information and the Commonwealth Budget. At face value, the super-sized 50 basis point cut would have been off the table. And a single 25 basis point reduction might have been a less than certain proposition.